Uncertainty is always a macroeconomic problem

 

" economic forecast are better than nothing, but their origin lies in extrapolation from a partially known past through an unknown present to an unknown future.."

- Denis Healey UK Chancellor of the Exchequer  1974-9 

I recently gave a talk on uncertainty or more specifically - VUCA - Volatility, Uncertainty, Complexity, and Ambiguity, and the above quote would have been a great way to describe the problem. We face more than just volatility. We really don't know the past of the where the economic has been. We don't always know where we are currently at in the business cycle, and our job is the describe an unknown future. 

The first challenge of macro investing is knowing where you are at before you make a judgment about where you are going. We have internal uncertainty based on our ignorance of the present which then must be blended with the external uncertainty of the future that may not be known because the underlying driver and relationships may change.

The direction of causality may change through time - the challenge for investors

This is still one of the key issues within macro-finance. What is the line of causality between the movement of two assets and what are the unknown drivers that may impact both assets? Tests of causality can be conducted, but that provides just a glimpse of what could be the driver of returns. 

The problem becomes even more difficult when looking at policy responses. Does inflation drive central bank action or does central bank action drive inflation? We know there is a relationship between the two; however, the direction of causality may change through time. Policy drives inflation until there is a point when the target variable drives policy. To be successful, an investor needs to anticipate the change in causality.

What is probability? It can be defined many ways

Probability pertains to a relative frequency of occurrence.

Probability is a logical relationship between evidence and belief.

Probability measures a subjective degree of belief.

Probability is a measure of the propensity to occur.

- From Willful Ignorance 

When we talk about probability, there is no simple definition. The above are four simple descriptions which provide insights on how to think about probability. It is work just sitting back and focusing on each one of the these. 

The Missing Billionaires - Worth the read regardless of your finance knowledge

 

Missing Billionaires: A Guide to Better Financial Decisions - This is a good book. It has been on several best books for the year in 2023. It is also an oddity. It is a book of investment advice for everyone, but it does not pull any punches with being simple and just wordy. It is grounded in modern finance with all the math that is necessary, yet it is still accessible and easy to read. Never has a set of authors done a better job of explaining the usefulness of expected utility and the use of core finance embodied by the work of Robert Merton. 

There are two core theses with this book. One, make sure you get your bet sizes right. Two, understand your expected utility through knowing your level of risk aversion. 

For the first point, understand the Merton share which like the Kelly Criterion states that the optimal bet size is related to your level of risk aversion time the expected return relative to volatility. There dictum is very clear. Do not take too much risk in any part of your portfolio. Temper your bets to ensure that you can maximize wealth through staying in the game.

The second point is critical for setting bet sizes, know and understand your risk aversion. You are not indifferent to risk and this aversion can be measured. When risk aversion is measured, it can help set bet sizes and portfolio risk. 

The amazing part of this book is that seasoned investment professionals will get a lot from this work just the same as a novice. Even someone who has studied formal finance will find their framework thought provoking and useful.